Macro review

In the US, the third quarter saw increased political uncertainty amid rising tensions between the US and North Korea and the ongoing failure of the Trump administration to implement its policy goals. These tensions were a key factor behind the temporary rotation into lower-risk assets in August. In the wake of hurricanes Harvey and Irma, economic data and activity indicators deteriorated towards the period end. However, capital markets discounted the potential negative impact on growth as minimal, as did the US Federal Reserve (Fed) in its statement following the latest Federal Open Market Committee meeting. At this meeting, the Fed kept interest rates steady but confirmed that measures to reduce its balance sheet would begin in October, despite persistently weak inflation.

In the Eurozone region, economic data remained robust over the prior three months. GDP growth was confirmed at 0.6% in the second quarter, up from 0.5% in the first quarter. Economic sentiment rose to its highest level since July 2007, while unemployment in the Eurozone remained at 9.1% in August, which was stable compared to July, and the lowest rate since February 2009. The possibility that the European Central Bank could reduce its stimulus measures continued to be a focus for the market, as the committee kept policy rates unchanged in September. Also noteworthy was Angela Merkel winning a fourth term as the Chancellor of Germany in September. For the UK, the economy showed clear signs of slowing down, while inflation picked up, reaching 2.9% in August. During the quarter the Bank of England struck a more hawkish note with Governor Carney and a number of members of the Monetary Policy Committee openly discussing rate rises.

Emerging markets saw a positive economic backdrop of steady global growth, modest inflation, US dollar weakness and a continued momentum in the Chinese economy through a pickup in commodity prices. In China, Industrial profits rose 20% year-on-year in August vs. 16.5% year-on-year in July, driven by a rebound in industrial prices. In South Africa, the South African Reserve Bank (SARB) lowered the repo rate by 25 basis points (bps) in July, yet surprised markets by keeping the policy rate steady at 6.75% in September. GDP growth momentum recovered in the second quarter to lift by 2.5% (quarter-on-quarter, seasonally adjusted annual rate) after a brief technical recession in the first quarter.

Global and local market review
Global equity markets advanced in the third quarter with the MSCI World Index returning 5.0% in US dollars, and 16.5% year to date (YTD). This advance was largely driven by stable economic growth, benign inflation and positive earnings releases. Emerging market equities, however, outperformed their developed world counterparts, returning 8.0% during the third quarter and 28.1% YTD, in dollars. This streak of outperformance ended in September after eight months of positive relative performance. Top performers in emerging markets in the third quarter were Brazil (+23%), Russia (+18%) and Chile (+17%), while Pakistan (-16%), Greece (-12%) and Qatar (-7%) were the laggards. Brazil saw some reform progress and central bank easing, while Russian equities rallied as crude prices picked up and lower inflation opened the door for further interest rate cuts. In contrast, Pakistan’s market was weighed by their Supreme Court’s disqualification of the prime minister, while Greece declined amid a sell-off in banking stocks.

Year to date, South African equities (Swix) delivered a healthy 10.6%, underperforming bonds (+4.0%) and cash (+3.7%) as commodity prices rallied andrate expectations buoyed equity markets during the third quarter. Over the quarter, the Swix returned 7.0%, driven by Materials (+17.8%), while Industrials (+7.4%) and Financials (+5.1%) also rallied. Within Industrials, Naspers (15.0%) continued to outperform on the back of a strong performance in Tencent. Interest rate-sensitive sectors such as Retail and Banks also bounced in early in the third quarter, around the first rate-cut in July, although the SARB surprised markets in September by keeping the policy rate steady at 6.75%. MTN (+11.2%) also drove the equity market as MTN’s new management conveyed its aspirational growth potential, while Aspen (+5.7%) rallied after announcing the AstraZeneca (AZN) deal.

Portfolio performance, attribution and strategy

The S&P Quality Index experienced a challenging first half of the year, as the market grappled with inter-changing risk-on and risk-off environments. Predictably, during the months of February and June where the South African equity market (Swix) experienced deep negative returns, the S&P Quality Index provided meaningful protection. Over the third quarter, however, the strategy started to gain substantial traction relative to the Swix, as investors preferred counters with high profitability and strong balance sheets to weather the market volatility. Noteworthy was the portfolio’s strong relative performance during positive equity markets such as July and August, illustrating the strategy’s ability to keep pace through cyclical upswings. The strategy’s diversification benefits have also been of significant value within this factor portfolio construct.

The largest relative outperformance over the quarter came from the overweight positions such as Kumba Iron Ore (KIO), Exxaro (EXX), Mr Price (MRP) and Assore (ASR), as well as underweight positions such as Steinhoff (SNH) and British American Tobacco (BTI). By not holding Naspers (NPN), the fund substantially detracted value relative to the Swix, while holdings in Anglo American (AGL), MMI Holdings (MMI) and Tiger Brands (TBS) also diminished the strategy’s value-add. There were no constituent changes to the S&P Quality Index over the prior quarter, as this index rebalances in June and December each year.

The index and portfolio remain focused in its extraction of Quality and should markets give way to further risk aversion, the defensive character of the basket should prove rewarding while not meaningfully compromising returns during up markets